Fair value adjustments and some quirky accounting rules

I am pretty convinced that the purpose of a lot of IFRS edicts is to make financial statements unreadable. The introduction of IFRS 16 adds two lines to most companies’ balance sheets and while mildly annoying (mentally one has to make a provision for lease-heavy companies that the amortization of the lease asset/liability is akin to a lease payment and make sure not to perform apples-to-oranges comparisons when looking at EBITDAs), the biggest pain has to be IFRS’ tenancies to use mark-to-market fair value adjustments whenever such data is available.

As an example, I am going through Gran Colombia Gold’s (TSX: GCM) last quarterly statement and the income statement is getting to the point where it is almost unreadable.

For example, under “Other income (expense)”, the entire $4.591 million under “Loss on Financial Instruments” consists of fair value adjustments. For an untrained eye these would seem quite relevant in that one would perceive the company is ‘paying’ more in financial expenses than is actually the case. From an analytical perspective, these fair value adjustments are irrelevant.

I’ll break down this even further, which is covered by the rules of IFRS 9.

$2.569 million of the $4.591 million consists of a mark-to-market adjustment on the fair value of warrants the company has outstanding.

When the company issued the warrants in conjunction with a notes offering, they issued 12.151 million warrants which were publicly listed on the TSX (TSX: GCM.WT.B). The warrants are convertible at CAD$2.21/share.

Let’s step back and remember the following law of accounting:

Assets = Liabilities + Equity

In a sane world, these warrants should reflect equity (the warrants in no circumstances can ever reflect a drain on the assets of the company). However, in our brave new IFRS world, they are a liability because they represent value that has not been set at a fixed price by the company. GCM reports in US currency, so therefore the warrant liability in Canadian dollars is a floating obligation and thus needs to be re-valued every quarter!

Once the door was open to expensing stock options, the logical progression is that any issuance of like instruments (such as warrants) need the same treatment.

Since the warrants are publicly traded, the fair value of the liability can be recorded using the market price. This needs to be updated quarterly.

The warrants at the end of December 31, 2018 were worth $13.8 million. On March 31, 2019 they were worth $16.4 million. Therefore, the company “lost” $2.6 million and this has to be reported on the income statement as a financial expense.

This expense, in no manner, reflects an actual cash expense. Nor does this expense affect the valuation of the company in any respect. This “expense” does not impact the taxes the company has to pay.

What it does, however, is really skew any ratios that may need to be calculated. For example, if you have an excessively high non-cash expense due to a fair value adjustment, it would serve to understate your net income, or make your apparent tax rate higher than it actually is.

Perhaps this is why most people do not read financial statements anymore – they’re becoming more and more difficult to read.

However, opportunity exists in complexity – if computer programs that are designed to screen for fundamentals do not factor in irrelevant expenses such as these fair value adjustments, companies that appear to be losing money on the income statement could be undervalued by the market as standard stock screens will report them as less profitable than they actually are. I’ll leave it at that.

Administrative issues on website

On popular demand, I have added an “E-Mail Subscriptions to New Posts” option, which is available on the right-hand side of the website on desktops. For those squinting their eyes on a 4 inch mobile phone, you’ll have to flick all the way to the bottom. Fill in your name and email, and once you confirm your email address the site will notify you of new posts.

There are also third-party providers that will do active monitoring for changes in websites.

Finally, I have always maintained a full-post RSS feed (http://divestor.com/?feed=rss2) and highly suggest NewsBlur if you are looking for an RSS reader.

Enjoy.

Generalized market thoughts

Here are a few more general thoughts on the markets:

1. As long as American oil producers are able to pump progressively higher amounts of crude oil, Canadian producers will always be at a relative disadvantage to the USA unless if they develop a proper export facility that goes outside the USA. This is a very well known fact, and one of the reasons why even if the federal government changes this October, it will still be quite some time before Canadian oil producers reach the glory days like they did a decade ago. The completion of the expansion of Enbridge Line 3 (late 2020) will alleviate this somewhat but ultimately, Canada will receive full price for its crude oil if they can export elsewhere. Good luck!

2. The dynamics for natural gas are a little different. While domestic production exceeds domestic consumption, there is the promise of BC’s LNG project near Kitimat, which is expected to be active in 2025. What will be interesting is if any court challenges will stall the project out like the Trans-Mountain pipeline. In general, natural gas producers (and there are a handful of them to look at) look more promising from a valuation perspective than do crude oil counterparts. They have both been hammered as AECO pricing has been terrible – again, there is just no way to get rid of the product when the USA’s own production has been expanding like no tomorrow.

3. The acronym TINA – There is no alternative – is what explains a lot of what I see in equity pricing. If you are a pension fund manager, and your expected rate of return is 7%, you can invest in some BBB-rated bonds and get a 4% return. You need to pile onto the equity in order to make up the the other 3% for the remaining part of the portfolio. When equity prices fall, in order to generate the extra needed return, you rebalance and purchase more equity. With central banks very loose with money supply, there remains ample firepower to throw into equities – and it doesn’t matter what equities, as long as they are as liquid as possible.

I have no idea when this blows up, but I suspect when it does, it will be very, very quick – similar in scope to December 2018, or the crash of the inverse volatility ETFs which happened in February 2018.

There will be pockets of safety here and there, but everybody remembers what happened in 2008 – mostly everything got sold down, no matter how attractive the assets were.

Rosetta Stone valuation question

I’ve been busy reading quarterly reports.

One flashback from the past (something I flipped around within a single calendar year, many years ago) was a software company called Rosetta Stone (NYSE: RST). They have over the past decade shifted and adapted to the subscription-based system, and also bet a good chunk of their cash on Lexia Learning, an English language training software.

Today I examined them and read the financial statements of their last quarterly update without looking at their stock price, and see that the underlying operation still is not generating cash and they are struggling to keep their high margin revenues (namely – there is quite a bit of competition in the language learning space and also the barriers to compete in this market are not that high).

There are two salient accounting points to this firm that is relevant in the analysis – the product is sold in advance, which means that the company can collect the cash today but recognizes the revenues over the course of the term of the software license.

As a trivial example, if I write software and then sell it to you to use for two years for a hundred dollars, I would today show 100 dollars of cash on my balance sheet and 100 dollars of deferred revenue (50 current, 50 long-term). In the subsequent two years, I would book 50 dollars of revenue and reduce the deferred revenue amount accordingly – I do not receive any more cash.

Likewise, RST has $146 million in deferred revenues on their books which will be ‘guaranteed’ revenues over the next couple years. This is cash that is already collected, which means the valuation depends on how much future cash they can collect – the revenue figure is a lagging indicator.

In Q1-2018 to Q1-2019, deferred revenue climbed up from $140 to $146 million, which is a reasonable sign for the company. But hardly a rocket launch.

The other item that is worth pointing out is that RST capitalizes some of their “internal use software” expense – instead of expensing it out to R&D, they pack it on the balance sheet. This is expected to be around $20 million of expenses for the year, which is not a trivial amount – the way the company “masks” this is to focus on the operating cash flow figure, which does not include this inconvenient “internal use software” expense.

Certainly the projections from Q1-2018 to Q1-2019 and the year-end 2019 projection show a slow positive trajectory – EBITDA is up and the cash burn is slowing down to nearly nothing – and presumably more deferred revenues will show on the balance sheet. The entity is debt-free, has a bit of cash on the balance sheet (roughly $28 million now, projected $38 at the end of the year).

How much would this be worth? Let’s say 1.5 times sales – which is already generous given the competitive nature of their particular software market.

Then I looked at the stock price. Oops.

What the heck happened that warrants such a valuation?

I shook my head and moved on.

Whether it is marijuana or language learning software, there is a lot of capital being thrown into companies in industries that have relatively few competitive barriers. Is this just because the low interest rate environment has left nothing to throw capital into?

Asset stripping in inter-corporate relationships

Whenever researching companies that have control over other corporations, it is quite important to pay attention to signs of agreements between both entities that are to the benefit of one or another. Today’s example is fairly textbook.

This news release from Dream Asset Management (TSX: DRM) hit my mail feed this morning:

TORONTO, April 23, 2019 (GLOBE NEWSWIRE) — Dream Unlimited Corp. (TSX: DRM) (TSX:DRM.PR.A) (“Dream”) announced today that Dream Asset Management Corporation (“DAM”) has agreed with Dream Hard Asset Alternatives Trust (the “Trust”) and Dream Alternatives Master LP (“Master LP”) that until December 31, 2020 the management fees payable to DAM pursuant to the management agreement of the Trust will be satisfied in units of the Trust (“Units”) valued at the recently reported net asset value per Unit of $8.74 for purposes of determining the number of Units to be issued, subject to the receipt of required regulatory approvals and unitholder approval at the upcoming meeting of unitholders of the Trust to be held on June 17, 2019. DAM has agreed to accept Units in satisfaction of the management fees in order to increase its ownership stake in the Trust and to preserve the business’s cash to support the cash distributions by the Trust while the Trust seeks to increase the market value of the Units by offering to purchase Units. As of the close of business on April 22, 2019, DAM and its joint actors own 13,386,072 Units representing approximately 18.6% of the issued and outstanding Units.

Notably, Dream Unlimited and Dream Hard Asset Alternatives (TSX: DRA.UN) are run by the same management team. When skimming through the financials of DRA, the bulk of their portfolio consists of various real estate ventures ($118 million), equity-accounted for investments in the real estate sector ($133 million), commercial/development lending ($144 million), income properties ($224 million, notably shared with two other related Dream entities), a solar and wind power asset ($130 million), and finally some cash ($47 million). On the liability side, they have $195 million in loans outstanding, most of it ($123 million) mortgage loans.

Book value is $592 million. Trust units outstanding are 72.6 million, so the NAV at the end of December 2018 is $8.15/share. (I know the above release cited a $8.74 NAV – this is reconciled on page 2 of the MD&A but it is not terribly relevant to this post).

The trust reported $8.3 million in operating income, plus another $3.3 million in interest income, for a total of $11.6 million before taxes (note as a non-REIT trust they would pay a tax on income distributions, but since those distributions are mostly return of capital at this point the taxation is entirely within the consolidated portions of their asset portfolio – a great future CPA taxation topic I would be more than happy to write about!). At their stated distribution rate of 40 cents per unit, they would require $29 million a year to pay this.

The summary is that they are holding onto a lot of private assets and while they can likely be liquidated in the medium term (especially the real estate holdings), in the short term they are distributing more cash than they are able to generate without selling such assets. They are not in a desperate situation and have the luxury of time to optimize matters.

Likely due to the controlled ownership situation, coupled with the illiquidity of their underlying portfolio, they are trading at a discount. Before today’s announcement they were trading at $7.20/unit, so they were about 11% under the GAAP book value, and around 18% using management’s revised NAV estimate.

At the same day, DRA announced:

As part of its strategic plan announced on February 20, 2019 to enhance unitholder value, management and the Board confirm that the units of the Trust are an attractive investment opportunity and are committed to deploy up to $100 million towards its unit buyback program (representing just under 20% of current market capitalization). Providing further clarity on the execution and timing of the unit buyback program, the Trust now intends to make three offers to unitholders in accordance with applicable securities laws, the first of which is expected to be made on or about July 15, 2019 for approximately 4 million units at an offer price of $8.00 per unit and two subsequent offers will be made in 2020 for $30 to $35 million of units at prices of at least $8.25 and $8.50, respectively, for a total buyback of $100 million of units prior to the end of 2020. These buybacks compare to the closing price of the units on the TSX of $7.17, as of April 18, 2019. The exact number of units that the Trust offers to purchase and the timing of such purchases will be determined by the Trust at the time of launching such offers subject to the receipt of the expected proceeds from capital recycling and the trustees’ obligation to act in the best interests of unitholders. The Trust has been advised that Dream Asset Management Corporation, the Trust’s asset manager and an 18.6% unitholder does not intend to tender any units to such offers.

In this release is a non-binding promise to initiate a partial tender at prices above current market value.

DRM’s entitlement in 2018 was $13.6 million. By opting to receive units at $8.74 compared to today’s market value (currently $7.70/unit), assuming prices, the management fee, and NAV remains constant, DRM has opted to graciously donate about $1.6 million to the unitholders of DRA. While this is not a gigantic amount of capital in relation to the sizes of the entity, it does give a hint as to where management is prioritizing the reception of its capital allocation.

This is another example of how a related party transaction is a red-flag show stopper with regards to an equity investment prospect. Dream Unlimited is relatively cheap in theory, but to invest in it you have to completely in for the ride with regards to the whims of management (the control character is Michael Cooper). This has not prevented me in the past, however, from investing in what used to be the best and nearly risk-free 7% eligible dividend in the form of (TSX: DRM.PR.A), but sadly the market has gotten smart about it and management should be calling it when they wish to realize the quickest 9.2% pre-tax use of capital.

Hat tip to Tyler on Twitter for this one. I had intended to write about this when it hit my inbox, but I saw that he wrote about it first.